Fred Hilmer

The proposal by NBN Co that it should be freed up to allow it to compete with rival private operators such as TPG Telecom highlights the dilemma facing government when it seeks to achieve a social goal by creating a monopoly.

The NBN’s competition policy problems began from its conception when it was established as a legislated monopoly. The justification was that a monopoly, given its substantial power to set prices, would be able to offer an equivalent service at an equivalent price to all Australians, whether in the remotest outback or the high-density parts of the cities.

This goal, to be met via a monopoly (rather than a competitive model with transparent subsidies) was argued to be the best approach to establishing universal high-speed broadband access.

The NBN, however, is not a natural monopoly. The basis of the NBN monopoly is regulation, not economics. Natural monopolies – such as the electric power grid, the rail track or gas and water distribution networks – cannot be economically replicated by a competitor. Natural monopolies have considerable power to set prices without needing legislative protection and, hence, are subject to structural separation and price regulation.

Monopolies created by regulation rely on the regulatory barrier to be able to set prices and price structures. Without regulatory protection, much of what monopolies such as the NBN would like to do can be picked off by competitors, as TPG has demonstrated.

Hence, the only way the NBN monopoly can be protected is by cast iron, loophole-free regulation. However, monopolies created by regulation are inherently fragile. As George Stigler wrote, “Competition is a tough weed, not a delicate flower”. And tough weeds find even small cracks in the pavement to break through.

In the case of the NBN, there are two major “cracks in the pavement” that are becoming apparent even before the NBN is built. The first is cross-subsidy. Urban users have to pay more than the costs of serving them, while remote users pay less than cost. As a result there is an enormous incentive for potential competitors to break the monopoly and serve urban users at lower prices that nevertheless produce good profits. TPG may have found a loophole that allows this.

But I can confidently say that even if this loophole is closed, others will emerge. The reason is because of an even larger crack in the monopoly pavement – new technologies that erode monopoly power.

We have seen how legislated restrictions on competition can be blown away by technology. One need look no further than the media industry where cable and the internet have eroded the value of legislated TV licences. Importantly, these new technologies have created jobs and supported economic growth.

These two forces complement each other, as the financial incentive in serving the most attractive customers triggers technological innovation.

And herein lies the real dilemma, so often ignored when competition policy is debated. It is generally clear what competition, if allowed to work, will do to inefficient competitors or the products and services that are overpriced.

These consequences are highlighted as doomsday scenarios — the end of important and much loved activity and employment, such as an aircraft maintenance base or a call centre. Moreover, the pain is felt acutely by few, who can be quite vocal, while the benefits are diffuse.

But what is left out, and is generally unforeseeable, is the range of new jobs and new opportunities a competitive environment creates. Recall what happened when airlines were deregulated. Jobs were lost in the airlines, but far more jobs were created as coastal communities developed tourism and the second home market on a scale not imagined when the deregulation was proposed.

What then should the government do — keep cementing over cracks in the pavement, or accept that the monopoly is neither sustainable nor in the public interest? In the latter case, look after the remote users by direct subsidy rather than relying on an unstable monopoly? Maybe it is too late for such a fundamentally different approach.

But maybe the adage, “the first loss is the best loss” will again be proved right.

Professor Fred Hilmer is the vice-chancellor of the University of NSW. This post has appeared in The Australian Financial Review.

Geoffrey Garrett

As I prepare to take up the deanship of The Wharton School, I have been reflecting on the differences between business education and higher education more generally in Australia and the US.

The structural forces shaping universities are the same as those changing business. The combination of globalisation and technological change represents a brave new world, but with dislocations too. But there are at least four key differences between Australia and the US when it comes to the on-the-ground realities of higher education.

First, while the growth of Asian enrolments in Australian universities has slowed in recent years, Asian students are flocking to the US. Australian universities largely had Asia, particularly China, to themselves for much of the past decade. Now the high dollar and better Asian universities seem to have capped Australia’s (large) market share.

Elite US private institutions such as Wharton have long recruited students globally. But they are more concerned with quality than revenue, using big scholarships to attract the best talent.

In contrast, US public universities have jumped into Asia to compensate for reduced public support following the financial crisis, becoming very Australian, very quickly.

UNSW and its Australian peers offer quality education. But we don’t have the global brand power of Berkeley or Michigan, a problem in hyper-brand-conscious Asia. If Australia wants to defend its place in the global higher education market, it will have to think about new ways to attract Asian students.

Australian universities are already using dual degrees with Asian universities. They are also improving residential facilities and student services. But innovative uses of technology and more opportunities for “doing” rather than just studying must be added.

The second difference concerns philanthropy, with private giving to US universities at least an order of magnitude greater than here. The University of Pennsylvania, of which Wharton is a part, recently completed a five-year philanthropy campaign that raised more than $4.5 billion.

In a vanguard campaign, the University of Sydney attracted gifts worth about $300 million during the same period. With a few outstanding exceptions — Frank Lowy at UNSW, then John Grill at the University of Sydney and, most recently, Andrew Forrest at the University of Western Australia — we simply do not have a strong and deep philanthropic culture of giving to universities.

Westpac’s $100m fund to provide 200 university scholarships a year is a fillip that should not be used to justify federal funding cuts. With tight government budgets likely for a decade or more, growing philanthropy is a critical priority for Australian higher education.

My third observation concerns research. The Group of Eight has shown that the funding available to our best researchers falls far short of the US and Europe. But there is another, crucial, piece of the puzzle where Australia lags well behind the US — supporting the full costs of research. In addition to the direct costs (research time and equipment), research requires lots of indirect support (from buildings and laboratories to accounting and custodial services).

According to the Association of American Universities, the “indirect cost rate” US universities receive from government funding agencies is about 50%. That is, for every dollar in support a research team receives, the university employing the team gets an additional 50c to defray the costs that make the research possible. The comparable indirect cost rate for Australian universities is about 20%.

If we assume US research is realistically funded, that means Australian universities have to add 30c for every dollar in support they win from the Australian Research Council and National Health and Medical Research Council. The better a university does in attracting research grants, the more money it has to find to make this research possible.

This is where business schools enter the story. Australia has the largest business schools in the world in terms of student numbers, and they have the largest proportion of full-fee paying students in Australia. Teaching revenues support research in our universities and much of the funding burden falls on our business schools.

This puts Australian universities in an invidious position. Focusing more tuition revenue on teaching would damage research. But cross-subsidising research leaves less money to focus on imperatives like smaller class sizes. The only way out of this double bind is for ARC and NHMRC competitive grants to include the appropriate indirect cost recovery rates.

My final observation concerns the funding of university courses in Australia. One way to free up government money to fully fund research would be to reduce direct government support for teaching — by deregulating the fees our students pay.

This would be a double win. The cost of teaching born by government would be reduced. But the revenues available to universities to improve teaching would increase. The focus here should be on degrees that have large private benefits — that is, which substantially add to a student’s lifetime earnings.

Business schools are largely “private benefit” educators. Yet we charge Australian students nothing like the market price for our undergraduate business degrees. The Australian government gives the Australian School of Business a little more than $12,000 a year for each (full-time) Australian undergraduate student. Of this, students pay about $10,000. Only about $2000 of a “Commonwealth-supported place” is actually paid by government. At the same time, our international students pay more than $30,000 to sit in the same classes. Wharton undergraduates pay about $50,000 irrespective of where they’re from.

A UNSW business degree is “worth” more than $12,000; just ask the very large number of the best Australian students who apply. Deregulation of fees would allow us to charge closer to the market price. Any adverse impact on access would be mitigated by the Higher Education Contribution Scheme.

HECS allows Australian citizens and residents to defer all the costs of their undergraduate degrees until they are in full-time employment following graduation. Repaying educational costs is then subject to progressive taxation.

So my take on the future of Australian higher education as I get ready to return to the US: Asia will be tougher; philanthropy will be more important; research should be fully funded; and undergraduate fees should be deregulated.

Everyone knows universities are at the heart of improving society, from educating better citizens to driving job growth to inventing the future.

We sometimes forget that business schools are integral parts of our universities, too.

This Opinion Piece previously appeared in The Australian. Geoffrey Garrett is dean of the Australian School of Business. He joins The Wharton School of the University of Pennsylvania on July 1.

Jenny Buchan

The Australian government is moving to introduce a new Franchising Code of Conduct as part of wide-ranging reforms to how franchising arrangements are regulated, claiming it will be fairer for small operators and cut red tape. Whether that will happen is far from certain.

The proposed changes will only apply to franchise agreements signed from the start of 2015. The biggest changes are the introduction of a specific duty of “good faith”, and the requirement for franchisors to give prospective franchisees an “information statement”.

These changes are accompanied by legislation that will give the regulator, the Australian Competition and Consumer Commission, the ability to impose financial penalties on franchisors that breach the code, whereas it wasn’t able to before.

But the changes would leave some of the fundamental problems affecting the relationship between franchisors and franchisees – namely knowledge and power imbalances – unfixed.

Knowledge and power imbalances are the Achilles heel of franchise relationships. A franchisor builds a business, creates a blueprint of it, and licences franchisees to replicate it using the blueprint. With power over the content of the agreements comes scope for abuse. Franchisees sign the agreements with little ability to negotiate changes.

The first Franchising Code of Conduct in 1998 attempted to bring balance to franchise relationships. It mandated pre-contract disclosure, specific rights such as a cooling off period for franchisees and established a dispute-resolution system based on mediation.

However, eight more franchising reviews have been conducted since the code was introduced, suggesting it has not achieved its objective of raising standards of conduct in franchising.

The current proposals have come out of the 2013 Wein Review. It made recommendations in eight broad areas: disclosure, franchisor failure, transparency of financial information, good faith, the end of a franchise agreement, dispute resolution, enforcement and “other matters”.

Most recommendations weathered the subsequent change of government.

The most significant change, Wein’s recommendation for a “good faith” clause, has been adopted. But a party to a franchise agreement does not have to act in good faith if this would get in the way of their legitimate commercial interests.

This means, for instance, that if a franchisor’s duty to its own shareholders is best met by selling the franchisor’s business to a property developer who wants the franchisor’s sites (even though this would mean the franchisees lose their businesses), the franchisees’ rights become secondary. This will only create a false sense of security for franchisees.

Another major change, the proposed information statement, is intended to address knowledge imbalances by providing franchisees with more information. But the change will only require a generic information statement, which assumes all franchise networks are the same, and that franchisees can already conduct adequate due diligence.

This overlooks the fact that every franchise is structured differently. Even within the same network different franchisees can be exposed to different risks.

A prospective franchisee, attempting to conduct due diligence, will still meet numerous impediments. Neither a franchisor’s disclosure documents nor its franchise agreements are on a public data base. This means potential franchisees cannot compare the offering before them with what is usually offered for franchisees in the same network, or with the franchise agreements of comparable businesses.

This is even worse if a franchisor operates through a trust, because the franchisee cannot discover who is behind the trust. And because dispute resolution processes are confidential, it is difficult to identify problems in the network.

Franchising has changed since 1998. Franchisors used to establish a successful business before franchising it. Now, according to the Franchising Australia Survey 2012, one-third of franchisors have operated their business for less than 12 months when they start selling franchises.

How can a business operating for less than 12 months be described as successful? And franchisors now exist within networks of, say, 40 related entities. Any due diligence on the franchisor is not indicative of how sound the franchisor’s related entities are.

The franchisor may itself be a “$2” company. If it is not performing well it can be placed in administration and restructured by shedding franchisees. The code should require disclosure of a full organisation chart showing how the franchisor fits into the group.

Perhaps the worst of the overlooked opportunities for reform is that of franchise failure. The franchisor retains the right to terminate the franchise agreement if the franchisee enters administration, but no reciprocal right exists for the more vulnerable party – the franchisees.

The government has returned the complex challenges that franchisor failure presents to the “too hard” basket. This is a missed opportunity to alleviate the knowledge and power imbalances that make life for franchisees that much more difficult.

Jenny Buchan is an associate professor in the school of taxation and business law at the Australian School of Business. A version of this post appeared on The Conversation.

http://theconversation.com/new-franchising-law-no-code-for-fairness-25154

Dale Boccabella

Abolishing the sacred cow of negative gearing – where losses can be used as a deduction against other income – is considered by governments of all persuasions as electorally unpalatable.

But this part of the income tax system is one of the few areas left which confers this highly favourable treatment. In many other important areas of our public finance and income tax system, negative gearing is effectively abolished in favour of quarantining of losses.

Negative gearing is allowed on passive rental property and share investments and for “large” businesses. Both the pros and cons of negative gearing are well-known. Its most immediate advantage is allowing taxpayers to use a loss on one investment as a deduction against a profitable investment, or other source of income. But it is accepted that it undermines the progressive nature of the income tax, does little to increase housing supply stock and is a significant cost to government revenue.

In contrast to negative gearing, quarantining is where the loss on an investment cannot be used in the year it is made, but can be used in future years, against profits from the same investment from which the loss arose. Usually, but not always, if the investment is sold while there are quarantined losses, these can be used to reduce the taxable profit on exiting the investment.

In our tax system, quarantining is used when determining whether a taxpayer is liable to pay the Medicare levy surcharge; for loan repayments under the higher education loan program (HELP); and assessment of income under the child support regime, particularly Family Tax Benefit Part A and B.

Quarantining also applies when the tax office is assessing means-tested concessions such as the dependent (invalid and carer) tax offset, or senior and pensioner tax offsets.

Small businesses that make a tax loss in a non-corporate form are not permitted to use that loss against other profits (so-called non-commercial loss rules). While these measures are in part a response to the ridiculous hobby tax loss claims of the past, these rules apply quarantining to genuine small businesses, including those in the start-up phase. Quarantining also applies to certain boating activities.

In the social security system, quarantining applies where a particular benefit is means tested, such as Seniors Health Care Card, or the parental income test for dependant youth allowance. Like the income tax though, quarantining is not universally applied under this legislation (for example, it does not apply to the income test for aged pensioners). Also, the current paid parental leave scheme also uses quarantining in its relevant income measurement.

So one can see that quarantining applies in numerous areas of our public finance system. The starting point for debate should focus on economic capacity. By allowing negative gearing, the loss is being treated as a genuine signification of reduced economic capacity to either contribute income tax (or other contribution), or to receive welfare assistance. On the other hand, if quarantining applies, the loss is not regarded as signification of reduced economic capacity to either contribute tax or to receive welfare assistance.

Unfortunately, there are credible arguments both ways. And the fact that countries around the world do not take a uniform approach to the issue under their respective income tax systems supports this.

However, our public finance framework ought to be internally consistent so that similar things are treated in a similar manner, unless there is a sound explanation for differential treatment. This should be the case within the social security and income tax system, as well as across both, as the social security system is the mirror of the income tax system, or a negative income tax.

Both systems have economic capacity at their foundation. Those with sufficient economic capacity make an income tax contribution, and those who lack it receive payments (and other non-money benefits) for economic support. Given the shared foundation of the income tax and social security systems, or that they are really one system, it is hard to see why a different measure of economic capacity should be used within each system or across systems.

Another lesser dimension is that tolerating negative gearing in parts of the income tax and social security systems, but not tolerating it in others parts of those systems, adds complexity. Differential treatment of the same thing necessarily adds to administration and compliance costs.

In the end, there is a real argument that negative gearing should either be restored in the areas where it is currently prohibited, or should be scrapped across the board.

Given where the debate is now, I doubt anyone will seriously argue the former. That tends to leave movement towards the latter, because no one would seriously argue that the current differential treatment is a principled position with credibility.

Dale Boccabella is an associate professor in the School of Business Law and Taxation at the Australian School of Business. This post appeared on The Conversation.

http://theconversation.com/why-its-time-to-quarantine-negative-gearing-24265